I’ve been working on raising a seed round for my startup, Teamly, and it’s become really clear to me from my experiences and from speaking to other entrepreneurs that the UK really lacks a culture of seed investing and this is starving potentially great companies from creating jobs and wealth. There’s no shortage of schemes to encourage and accelerate entrepreneurship, but what’s being done to get more people to get involved in angel investing here?

But what exists to encourage angel investing? Should we be encouraging people to set up businesses when there is a lack of capital to help nurture and develop these new businesses?

Perhaps you’re an individual of high net worth and you’ve heard about the excellent Enterprise Investment Scheme (EIS) tax breaks, if you went on to the HMRC website you wouldn’t exactly feel inspired. Even if you manage to find the official British Business Angels Association you will find just a one page introduction to angel investing. Come on guys, you can do better!

I have an example of the type of person we should be encouraging to angel invest: he is the founder of a very successful online retailer who recently exited for multi-millions to a publicly listed company. After 15 years of hard work this entrepreneur has bought a million pound house in the countryside and is sitting on the rest of his money while he relaxes. This is someone who has valuable domain expertise, and could really play a part in funding and advising the next generation but has opted out from that. This wouldn’t happen in silicon valley, where money is far more likely to be recycled, and a new generation of entrepreneurs and businesses are created with help from the advice and money of those who have gone before. I know there are countless other examples of successful entrepreneurs that somehow get into angel investing. It’s definitely a virtuous circle, if you received angel funding you’re more likely to subsequently become an angel.

It’s not just that we need more capital in the system to seed companies, but we need better quality angels as well. One unintended consequence of the EIS scheme is that it perhaps encourages those who aren’t really cut out to be an angel to look at it as an alternative to a deposit account. Dragons’ Den is perhaps a double-edged sword, while it definitely raises the profile of angel investing and entrepreneurship I cringe at the thought of the imitators across the country trying to be all hard nosed and dragon-like. (I met one such individual… shudder… not a fun meeting).

The existing angels we do have are also spoiled for choice because they are getting the opportunity to invest for equity on deals which ought to be funded by bank debt. This is down to our non-functioning banks who won’t lend even to established businesses with proven track-records. If you are an angel, with limited resources (money) and limited capacity (time) for doing deals, which would you rather go for? The seed stage startup doing something new and innovative which could be huge, but so far hasn’t delivered any revenue, or the long established company in a traditional sector you understand which just needs some additional capital to generate more revenue and profits?

What about VCs, are they seed funding startups? According to BVCA figures quoted in Management Today, funding for startups declined from £125m in 2009 to just £46m in 2010. This is another area where our friends in silicon valley do much better as there are far more VCs doing seed deals, and some that specialise in only these type of deals. The underinvestment in seed stages though makes it less likely the VCs will find those juicy later stage deals, because less companies will get to that stage without an influx of early capital. Without an infusion of capital early on many great companies are dying before they’ve even had a chance.

What needs to happen:

1. We need to raise the profile of angel investing and share best practice.

2. We need to encourage more “smart” angel investors to enter the system.

3. We need to encourage newer investors and other sources of “dumb” money to invest alongside “smart” money so that the money goes further and can help more startups.

4. We need to ensure the banks lend to the businesses that are bankable so that angel’s risk capital can be freed up for the deals it ought to be funding.

5. We need to encourage more VCs like Passion Capital to be set up and invest at earlier stages.

But who can make any of this happen? Fortunately this Government is listening and responding to matters involving the economy and job creation. Last night at an event organised by SkillsMatters I put some of these suggestions to Eric van der Kleij, the head of Number Ten’s new Tech City Investment Organisation and I was delighted with his positive response: He genuinely loved the idea to encourage more angel investing and said it’s going to the “top of the list”, and seemingly reading my mind said “there must be a TV show in this!”

Do you have an idea for how we can encourage this new wave of seed investing in promising UK startups?

Please contribute in the comments!

Here’s 3 ideas of mine to get the ball rolling:

1. Reach out to high net-worth individuals you know and ask them to consider angel investing.

The British Library’s Business & IP Centre is a superb resource for start-ups and established businesses alike. Last night I attended a seminar on Crowdfunding, looking at raising capital from multiple investors as an alternative to traditional routes from a handful of angels or VCs.

Charles Armstrong of Trampoline Systems

Crowd-anything is a hot topic, and there are a myriad of crowd based alternatives to problems and their traditional solutions:

Lending: Zopa

Mutual funds: cutefund

Startup capital: GrowVC

Contact data: Jigsaw

Encyclopaedia: Wikipedia

Embracing the crowd model to fund your business seems to make sense. Everyone knows that access to both debt and equity funding is much more difficult now than it was two years ago. Crowdfunding may fill a gap in the market, between seed funding when you are just setting up and growth capital from VCs which you will need to have a well developed product and revenue stream to justify. The sweet spot is probably from a few hundred thousand to a few million. The logic is simple, don’t rely on just a few limited sources for funding, but tap into investors world-wide. Avoid selling your soul to a VC when you can retain more control by having a greater number of smaller investors, and deal with them on your terms, not theirs. One class of share for everyone, no liquidation preference, no double dip, no ratchets and no more one-sided term sheets.

So why is everyone not doing it?

Charles Armstrong, CEO of London-based Trampoline Systems is a trailblazer who found that whilst the rules and regulations are dense and strict there are numerous grey areas, and these grey areas allow room for some innovation. Trampoline is close to raising £1 million in less than a year, so the approach has worked for them. Financial regulations are extremely strict about companies promoting investment opportunities, presumably to protect the individual from a plethora of get-rich-quick schemes which would otherwise appear. (I don’t see why this is so strictly controlled when it’s possible to gamble or borrow your way to massive financial problems).

It is illegal for private companies to promote investment opportunities in public. Trampoline’s solution: set up a website in isolation to promote interest in crowdfunding (but not directly promote Trampoline).

It is illegal for companies to discuss investment opportunities, to anyone who is not a sophisticated investor, high net worth individual or your friend or family. Trampoline’s solution: get people to self-certify they fall into one of these two investor categories on the Trampoline website before they are able to access anything further.

It is illegal for companies to send your business plan to more than 99 individuals. Trampoline’s solution: those people who made it into the restricted area of the website were given some additional information, for example, the minimum investment was £10,000, and they then had to get in touch by email and specifically request the business plan.

To be as fair to all potential investors as possible everyone investing was offered shares at the same price, on the same terms (BVCA approved articles) and given access to the same documents for due diligence (after signing a confidentiality agreement). I love this open and fair approach, but do wonder whether the addition of a lot of extra shareholders on such agreeable terms may limit your funding options for the future, and would turn off VCs.

Another perspective came from David Smuts of Elexu, who is instead incorporating as a public limited company, rather than a private limited company. Elexu aims to raise millions and give equity stakes to far more than the 100 person limit imposed on private companies. It is a myth that PLCs must be listed on an exchange, and the additional governance and legal requirements are only slightly more onerous than for a private limited company. The main drawback is that no matter the size of your PLC you must file full accounts with Companies House, including a profit & loss, not just an abbreviated balance sheet which is sufficient for most small private companies . Despite the extra cost and effort of being a PLC a small number of people choose to incorporate this way for no other reason than the perceived prestige.

The third speaker was Tony Watts of Keystone Law, who terrified and confused the audience with the severe penalties (both civil and criminal) for getting any of this wrong. Anyone looking to crowdfund will need specialist legal advice, and for that reason I’ve chosen not to repeat any of Tony’s specific advice here, I believe in this instance a little knowledge is a dangerous thing. Make sure you find one of the handful of law firms experienced in this and listen to David Smuts advice, “don’t pay your lawyer to learn this stuff at your expense”.

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These are my notes from a panel discussion, “Getting your company funded” by Justin Fishner-Wolfson at SXSWi 2010. Justin is principal of The Founders Fund, an early stage venture capital firm which is managed by past founders of tech start-ups. There were also occasional video contributions by Reid Hoffman, founder of LinkedIn.

The basics: what is the different between Angels and VCs? The most obvious one is the amount of money invested, although there is no firm guidelines, Angels will invest smaller amounts, sometimes up to $1m, (typically a lot less than that). Early stage VCs will invest up to a few million dollars, and in later rounds VCs may invest hundreds of millions of dollars. As investors will generally only invest in C corps it is therefore easier to incorporate as a C corp at the outset. An important point: angels should be accredited investors.

Questions that investors ask themselves:

Is the idea big enough?

Are these the right people?

Is the idea possible?

Having a big vision with big ideas and clear milestones is essential, but remember that early on people are mainly investing in you. The people aspect is also something the entrepreneur must consider, and it’s important to build relationships and trust before you need funding. Look for investors who you can get along with and you consider will add value to your business, and not just their money.

Reid Hoffman: “Taking investment is like marriage but after two powerpoints and a dinner”.

To build relationships before funding find people with a common interest and get them on board as an advisor. When the time comes ask if they are interested in investing. Look at their past investments and experience to ensure you are approaching those with relevant interests. Create an advisory board, and offer your advisors a fixed number of shares at the outset. [They will be diluted in the future, but this is acceptable as during the course of building your business your advisors will change over time as your needs change].

Does the VC’s “brand” matter? Mainly, it’s the PEOPLE who count, but the top firms have the best networks and the strongest track record.

Understand the terminology, and ensure you have an experienced lawyer that someone has recommend to you.

Common stock (for founders)

Fully diluted ownership (FDO) – after all options have been doled out FDO is the equity position of each investor.

Liquidation preference – a premium that the investor may receive when the company is sold. e.g. 2x LP means if they put in £50M and company sells for £100M then the investor takes it all.

Options (for employees – right to buy stock at a fixed price at a later date)

Option Pool – an amount of stock you agree to reserve for future employees. (You may not end up allocating all of this).

Placement agents – intermediaries who find and negotiate investment between start-up and investor. These are used more for larger rounds of funding and not for angel or early stage funding.

Prefered Stock (for investors – with more rights)

Warrants (similar to an option)

Share options for employees:

Generally the more money that you pay staff the less share options you give. Give people enough options that they feel motivated and be generous. Typically more equity will be offered if the company is riskier. Early employees may receive share options of anything from 0.5% to 15%.

Term-sheets:

Be careful to read and understand all the terms. Don’t just rely on your lawyer, read it all yourself and understand what you are agreeing to. Also pay attention to the issue of control, how the board is composed, voting rights/thresholds, who can sack the CEO and the voting mechanism for an acquisition. It’s important to set up the best possible terms at the beginning, as terms get worse over time and the last money in is the first money out. The key advice when dealing with the finer point is, get a good lawyer. One with a good network. The benefits of a good lawyer are they can provide great insights and advice. Remember to get recommendations and references on your lawyer.

Tactics:

Assuming you have been wooing investors for months, the best way to get commitment is to create a deadline. If you receive one term-sheet it is absolutely right that you let everyone else know you have a deadline looming and if they want a chance they need to put their term-sheet in too.

Jim Papp is the CEO of Podaddies, an angel funded online video advertising company, and he is an active angel investor in high tech companies. He is a member of the Band of Angels where he has served on the deal screening committee and has made about a half dozen investments in start-ups in the past several years with a focus on software and internet services, medical devices, and wireless technologies.

Jim started by giving a brief history of Silicon Valley, mentioning that although HP was founded in 1937 in a garage in Palo Alto it wasn’t until 1956 the first “silicon” business started in the valley. In 1968 Intel was founded, and in 1976, the same year I was born, so too was Apple in Steve Jobs’ garage in Los Altos.

The first angel group, the Band of Angels, was formed in 1994. Since then Angel groups have flourished world-wide, including Scotland. Of all the angel groups operating in the USA, 82% of them report making investments into software companies and 48% into telecoms companies. However, they do invest in a range of different industries but the failure rate is consistent, it doesn’t vary from industry-to-industry. More detailed facts and statistics available here.

ROI

52% of angel deals return nothing, or less than the initial amount invested

32% return between 1 and 5 times the original amount invested

15% Return greater than 5 times the amount invested

It’s for that reason that angels and VCs look for outsize returns, usually a minimum of 10 times amount invested; simply put, there are a lot of duds that need to be paid for.

The record year for investments by VCs was, unsurprisingly 2000, when an enormous $100Bn was invested. In a telling sign of that overheated period the average amount invested per deal increased significantly. In most years before or after 2000 the average amount invested has been between $20 or $30Bn. Sadly, 2009 has been significantly lower than this amount and shows there is still some way to go before confidence and level of investment returns to normality.

I asked Jim to explain why Silicon Valley still has an advantage for technology startups and he replied by quoting the famous crook who, when asked, “Why do you rob banks?”, sensibly responded, “Because that’s where the money is”. Out of all the VC money invested in the US, 38% is invested into Silicon Valley. As angels and VCs the world over tend to stick to their local area for investing, mainly out of practicality, startups continue to arrive. The odds are stacked against you though. Out of perhaps 70 pitches a month submitted to the Band of Angels, only 3 will get in front of the entire angel group, and only one of these will get funded.

The talk concluded with a summary of what investors look for in their investees:

Earlier this week I saw Richard Farleigh, one of the previous stars of Dragons’ Den, speaking at Clydebank College and giving a brief run down of his life, approach to investments and some of his successes and failures. His talk was memorable for his simple insights, not just because of the rather incongruous sight of a tanned Australian in this run down part of the West of Scotland!

Farleigh had a troubled childhood, taken into foster care at a young age – he was from a huge family and from a very tough sheepshearing background. Luckily Richard is really, really smart – and became a chess champion as a teenager. His first insight – unlike in chess, where you can play all the right moves and never lose, in business, you can still lose even if you do everything right. There is an element of randomness. That’s why it can be dangerous to listen to every successful and prominent entrepreneur – what worked for Richard Branson isn’t going to work for everyone else. And as another former Dragon, Doug Richard pointed out to me, survivor bias makes sure you don’t get to hear from those who tread the same path but failed.

So, as someone with over 70 investments how does Farleigh assess the winners from the losers?

First he looks for the essence of the business and tries to boil it down to the simplest concept, or equation. By saying that is what he is looking for suggests to me that a lot of businesses who approach him for financial backing are not able to communicate that to him. How many times have you seen people on Dragons’ Den who simply cannot explain what their product or service even is, never mind explain what the business model is and the likely return on investment?

Farleigh’s second investing rule is that a quality management team is more important than the product. The best product will fail with weak management, and a strong management can make almost anything work. After cutting his teeth in angel investing and building up his experience Farleigh changed from backing products to backing people.

The attributes he’s looking for in people: drive, passion, nous and commitment.

Finally, back to the metaphor with board games, he accepts that due to that degree of randomness he simply doesn’t get it right all the time.

If you want to know more about Richard Farleigh’s approach, his book, Taming the Lion has 100 investing secrets. More info at www.farleigh.com